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Taxing Intellectual Property Transfers

Outbound
transfers of intellectual property (IP) can
raise difficult issues for U.S. persons. One
scenario that illustrates this point involves
an outbound transfer of IP by a U.S. company
to a foreign subsidiary that then transfers
the IP to another lower-tier foreign
subsidiary.

Example: USCo
transfers Sec. 936(h)(3)(B) IP with a
seven-year useful life to controlled foreign
corporation CFC1 solely
in exchange for stock in CFC1 on day
1. Pursuant to a plan, CFC1 then
transfers the IP to CFC2
solely in exchange for stock in CFC2 on
day 2. The IP constitutes substantially all of
CFC2’s
assets. In year 3, CFC2
sells the IP to an unrelated
person.

USCo’s
transfer of IP to CFC1 is
subject to Sec. 367(d). CFC1’s
further transfer of that IP to CFC2 is
governed by Temp. Regs. Sec.
1.367(d)-1T(f)(3). The sale of IP in year 3
causes USCo to
recognize gain under Temp. Regs. Sec.
1.367(d)-1T(f)(1).

The transfer of the
property from CFC1 to
CFC2 solely
in exchange for stock in CFC2 also
creates an indirect stock transfer under Regs.
Sec. 1.367(a)-3(d)(1)(vi). As such, the second
transfer of IP subjects the transfer to the
rules of Sec. 367(a) and requires USCo to
file a gain recognition agreement (GRA) on
CFC2’s
stock or face gain on the transfer. Moreover,
CFC2’s
later disposition of the IP to an unrelated
person may trigger gain under Sec. 367(a).

The double transfer of IP creates a
transaction that is subject to the rules of
both Secs. 367(a) and 367(d). Because
regulations do not provide clear coordination,
the outbound transfer of IP could be subject
to both regimes. While subjecting the transfer
to a double tax seems inappropriate, it is
unclear which rules govern and whether there
is an ordering rule on which a taxpayer can
rely.

Regimes for Taxing
Transfers

Generally, under Sec. 351(a)
“no gain or loss shall be recognized if
property is transferred to a corporation by
one or more persons solely in exchange for
stock,” provided that immediately after the
transfer, the transferor is in control of the
corporation. However, when the transferor is a
U.S. person and the transferee is a foreign
corporation, under Sec. 367(a)(1) the gain on
the transfer is taxed, unless an exception
under Sec. 367(a)(2) or (3) applies, because
the foreign transferee is deemed not to be a
corporation for U.S. tax purposes.

Sec.
367(d)(1) provides alternative rules to the
Sec. 367(a)(1) gain recognition rule if the
transferred asset is an asset defined in Sec.
936(h)(3)(B). Under Sec. 367(d)(2), the U.S.
person is deemed to have sold the IP to the
foreign corporation in exchange for contingent
payments from the transferee foreign
corporation. The contingent payments have the
source and character of a foreign royalty that
is contingent upon “the productivity, use, or
disposition of such property.”

The
indirect stock transfer rules provide
additional guidance. Regs. Sec. 1.367(a)-3(d)
identifies several different types of
transactions that will give rise to indirect
stock transfers that are subject to Sec.
367(a). These transactions include a U.S.
person’s transfer of property (in this case
IP) in a transaction described in Sec. 351,
provided that the foreign transferee
corporation transfers some or all of the
property in a subsequent Sec. 351 transaction
to another foreign corporation. Under Regs.
Sec. 1.367(a)-3(d), the planned double
transfer of the IP in the example above should
give rise to an indirect transfer by USCo to the
extent of the IP that is transferred to CFC2.

Generally, a U.S. person is required to
file Form 926, Return by a U.S. Transferor of
Property to a Foreign Corporation, reporting
any Sec. 367(a) or 367(d) transfers in the tax
year of a transfer under Sec. 6038B. Under
Regs. Sec. 1.6038B-1(b), USCo would
be required to report the IP transferred to
CFC1 in
year 1 (i.e., the Sec. 367(d) transfer). USCo would
also be required to report the IP transferred
to CFC2 in
year 2 (i.e., the indirect stock transfer).
However, Regs. Sec. 1.6038B-1(b)(2)(i)(B)(1)
carves out an exception to the indirect stock
transfer reporting requirement, providing that
a U.S. transferor who owns “5 percent or more
of the total voting power or the total value
of the transferee foreign corporation
immediately after the transfer” must file a
GRA under Regs. Sec. 1.367(a)-8 instead of
Form 926. If USCo fails
to file the GRA on the indirect stock transfer
in a timely manner, the indirect stock
transfer is a taxable transaction.

Assuming that USCo filed
Form 926 for the Sec. 367(d) transfer and
filed the GRA (which often is overlooked) for
the indirect stock transfer in year 1, what
happens in year 3, when CFC2 sells
the IP to an unrelated person?

As
discussed, Sec. 367 prescribes two operative
regimes where intangible property is
transferred in exchanges described in Sec.
351. There are several reasons for adopting
the view that Sec. 367(d), and not Sec.
367(a), should apply to tax the IP in the
example. First, Sec. 367(d)(1)(A) provides
that Sec. 367(a) “shall not apply” when a U.S.
person transfers intangible property to a
foreign corporation in an exchange under Sec.
351 or 361. Second, Sec. 367(d)(1)(B) provides
that the provisions of Sec. 367(d) “shall
apply” in those circumstances. Under Sec.
367(d), Treasury was given broad authority to
address the transfer of IP, but nothing in the
regulations cedes that authority to Sec.
367(a) in this case. However, there is no
specific regulation that would influence a
choice between the Sec. 367(d) regime and the
Sec. 367(a) regime for purposes of the
example. Nevertheless, the contingent payments
referred to in Sec. 367(d) reflect
congressional intent to tax outbound transfers
that otherwise might escape taxation under
Sec. 367(a).

In light of this approach,
Sec. 367(d)(2) directs the tax on USCo to
reflect a contingent payment “commensurate
with the income attributable to the
intangible,” which likely factors into this
tax any appreciation in the intangible. Temp.
Regs. Sec. 1.367(d)-1T(f)(1)(ii) specifically
provides that USCo should
recognize a contingent payment commensurate
with the “part of its taxable year that the
intangible property was held by the transferee
foreign corporation and thereafter shall not
be required to recognize any further deemed
payments.”

Implications

Neither the
Code nor the regulations explicitly address
whether both Secs. 367(a) and 367(d) act to
tax the IP twice or whether one of the regimes
takes precedence over the other. Furthermore,
the IP could have either appreciated or
depreciated from the time of the transfers. If
the assets depreciate in value, Sec. 367(d)
may result in less gain; however, if the IP
appreciates in value, Sec. 367(a) may result
in less gain. This issue may be addressed when
the IRS and Treasury issue Sec. 367(d)
regulations or through a modification of the
Sec. 367(a) indirect stock rules. In the
meantime, taxpayers are left to struggle with
what appears to be a very difficult issue.

EditorNotes

Annette Smith is a partner with
PricewaterhouseCoopers LLP, Washington
National Tax Services, in Washington, DC.

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